Axel Weber, former president of the Bundesbank, who was
once thought to be the most likely successor to Jean-Claude
Trichet as head of the European Central Bank, where he was a
member of the governing council, is in no doubt that the key
uncertainty facing European financial markets next year stems
from the central bank he quit unexpectedly in 2011.

Now chairman of UBS, Weber says: "I think well see
new problems in Europe as the [ECBs]
asset quality review (AQR) and stress test is playing out,
largely because there will be a point in time when markets
start to ask what is the likely outcome for each of the 130
financial institutions involved. And unfortunately there are
many ways to
speculate on those outcomes, such as shortening the stock
or selling long positions."

It is widely assumed that the ECB, in its de facto first act
as lead regulator of Europes most important banks before
de jure taking on that role next November, cannot afford to
blow its credibility. If it does so, that would likely impair
its reputation as a monetary authority. And it is hard to see
how the stress tests, the final step in the three-part review
the ECB will undertake next year, can be credible without some
banks failing them.

Second step

Much attention has focused on the second step: the
ECBs asset quality review, looking at
banks likely NPL levels and current provisioning,
their collateral security against potential problem assets and
capital resources. But before this, the ECB will also assess
banks leverage, liquidity and funding before finally
finishing with the stress test itself. It will be interesting
to see how the ECB assesses the fact that there are large
swathes of the European banking system where the ECB itself is
the key provider of funding against diverse pools of loan
collateral that banks have parcelled up and submitted as
security for cash.

Axel Weber, UBS

Weber points out: At the November meeting, the ECB made a
clear commitment to continue with the full-allotment mode of
fixed-rate liquidity until 2015, thus signalling to the markets
that there will be no short-term liquidity issue for banks
while the asset quality review is taking place. But the ECB
also indicated that no decision had been taken with regards to
new longer-term funding operations, LTROs. That leaves open
whether or not all 130 banks post the stress test will all have
continued access to unlimited central bank funding. Thus,
demonstrating full access and availability of market funding at
low market rates will become a key sign of the financial
strength of banks next year.

The market is divided. In the weeks after the ECBs
initial disclosure of the surprisingly wide extent and timing
of its comprehensive review, some market participants tell
Euromoney that the stress test simply cannot be credible if it
concludes that Europes banks are safe when so many depend
on the continuing availability of
emergency funding from the ECB. But plenty also say they
simply do not buy the argument that the ECB will have to throw
one or two banks under the bus to prove how tough it is.

Maybe these optimists did not attend the conference in
Berlin last month where ECB executive board member Jörg
Asmussen warned: Credible national backstops must be put
in place. If not, the credibility of the whole exercise is put
at risk as the outcome will then almost certainly be negatively
perceived by market participants. Doing this balance-sheet
assessment without a backstop in place would be a bit like
getting on a boat in rough weather conditions and not taking a
life jacket on board.

He offers a sop to market purists by saying: Any
recapitalization needs uncovered by the exercise should of
course first and foremost be covered by the market,
before emphasizing that national budgets and national
resolution funds may intervene as a second line. Finally, a
European backstop, the ESM with its existing instruments,
meaning a banking sector programme
like in the case of Spain, may be available.

The ECB seems to be signalling that bail-in of bondholders,
even though it might be brought forward to 2015, should not be
the first method of repairing balance sheets found wanting by
its first regulatory review. But that uncertainty lingers
around bank debt.

Too far

John-Paul Crutchley, bank equity analyst at UBS, suggests
the rally in bank shares this year might be close to played
out, if it has not gone too far already. Generalist
equity investors tell us that they want to buy bank stocks as a
geared play on the
European recovery. But specialists in the financial sector
are worried by the continued drag from impairments in the
periphery, by dependence on ECB funding  which if it was
refinanced at market rates would certainly hit margins and
capital generation  and by the big fines that have hit
banks.

He says: Regulators certainly dont want banks to
over-distribute to shareholders, and with many recovered
banks shares trading close to book value and generating a
return on equity close to the cost of equity, its hard to
see much to get excited about from here.

Meanwhile, Barclays economists, led by Philippe Guding, see
broader risks to the European economy if banks hunker down
during the review. We think the timing of the AQR and
stress tests remains a material risk for 2014. The risk of
seeing the ongoing economic recovery foundering on a credit
constraint due to the unwillingness of banks to expand their
holdings of risky assets at the time of the banks
comprehensive assessment remains high.

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